In the competitive world of investment management you need to constantly improve to maintain your edge. We believe that a research focus is the only way to stay competitive and deliver strong performance. This means keeping up with the latest academic research, coming up with new ideas, and also performing extensive testing and analysis. Most importantly, developing good models requires that we approach investment solutions with an open mind. Some of the greatest inventions in history came from thinking about how to solve problems in a unique way when no one thought a solution was possible. At Blue Sky, we think deeply about all aspects of model development and how they affect real world implementation. Both constant innovation and a practical eye towards details are the hallmark of our research approach.
Most Recent Whitepapers
The Challenge of Being a Passive Investor
- Investors face the prospect of poor expected long-term returns making buying and holding less desirable for both equity and bond holders
- Given that bond yields are so low, investors are being forced to hold risky assets such as equities to earn sufficient returns. This forces passive investors to have to tolerate substantial volatility.
- Passive investing is more suitable for younger investors that contribute regularly since they dollar cost average over time which mathematically benefits from higher volatility. The reverse is true for investors in retirement that withdraw regularly over time and therefore their portfolios mathematically suffer from higher volatility.
- Passive investing is also psychologically unrealistic for “average investors” which is supported by evidence that they constantly underperform their comparable passive benchmarks by a significant margin.
Is there a better solution?
- Dynamic or tactical asset allocation strategies are some of the most effective forms of active management. They are especially useful to investors in retirement because they implicitly have a systematic methodology for managing risk.
- The primary purpose of these methods is to shift the efficient frontier to lower portfolio risk for the same level of return as a comparable passive approach.
Dynamic or tactical asset allocation has four potential benefits for investors in retirement:
- it can make the ride a lot more comfortable, thus preventing poor decision-making;
- it can reduce the risk of ruin
- it can increase the sustainable withdrawal rate
- it can boost returns and hence increase the final value of your portfolio
We compared several conventional passive strategies versus a number of different popular dynamic or tactical asset allocation approaches for investors in retirement. Using mathematical simulation we investigate whether dynamic or tactical asset allocation offers superior benefits to investors in retirement than a conventional passive approach.
Results of the Study
- The results show that the average active strategy has more than 3x the Gain to Pain Ratio (sustainable withdrawal rate/maximum drawdown) as the average passive strategy. Active strategies such as dynamic/tactical asset allocation have offered retirees a superior trade-off in terms of the level of sustainable income versus their expected maximum risk or worst case scenario.
- The results show that the average active strategy has less than half the risk of ruin or odds of running out of money as the average passive strategy. In other words, active strategies can help retirees reduce the risk of running out of money versus employing a passive strategy
- The results show that the average active strategy has more than double the sustainable withdrawal rate as the average passive strategy
|Discipline:||Decrease the likelihood of making emotional decisions during periods of market turbulence.|
|Recovery:||Minimize the time required to recover from portfolio drawdowns by limiting or eliminating losses during bear markets.|
|Preservation:||Reduce portfolio volatility to lower the risk of a devastating financial loss, one that could derail retirement objectives.|
|Income:||Maintain a sustainable level of portfolio withdrawals for cash flow and retirement income needs.|
Long ago the investment industry came up with the clever idea of using benchmarks to compare the performance of their portfolios relative to an ‘objective’ reference point. The idea sounds sensible on the surface – investors have more choice of products to invest in than ever before – why not have some yardstick to compare them?
The conventional method for portfolio management in the industry is to create portfolios with static weightings across asset classes. Different portfolios are created for investors with different suitability profiles. Rebalancing to policy weights is done perhaps once or twice per year. This is called a strategic asset allocation approach, and is the most widely used method in the industry. The greatest debate in the industry seems to be whether to hold passive index funds or ETFs versus actively managed mutual funds within this strategic asset allocation framework. We think that both camps are missing the ‘big picture.’ It is the asset allocation that matters, not the choice of components. Closer inspection reveals that the research does not support a strategic approach as being optimal for investors. Furthermore, investors have a hard time sticking with a strategic allocation. Evidence for this premise is demonstrated by their poor realized investment performance versus nearly any industry benchmark. Instead, research shows that a Dynamic Asset Allocation approach is optimal from an investment management perspective and may be easier for investors and advisors to stick with in the long run.
Dynamic Asset Allocation from an investment perspective implies that we change portfolio weights in response to movements across global financial markets. A large rise in interest rates for example should change our expectations for the future. Modern Portfolio Theory (MPT) tells us that a change in expectations should yield a mathematical change in portfolio allocations. These expected inputs can be generated using different factors in the quantitative field. The challenge is to figure out what factors to focus on and how to use them effectively. Momentum is the tendency of past trends to continue in the same direction. An asset that has been trending upwards generally tends to continue going up. Similarly, an asset that is outperforming other assets on a relative basis generally tends to continue to outperform. Therefore, a simple and effective model for asset allocation can use various forms of momentum analysis to determine: 1) which assets are likely to perform the best (or worst) and 2) whether they are likely to have positive (or negative) performance. Momentum is well-accepted in academia, and is considered the most pervasive anomaly in finance. More importantly momentum has been used exclusively by some of the best investment managers in the world. Using momentum within a dynamic asset allocation framework can potentially enhance returns and reduce risk.
We are commonly asked about the method we use to tilt our Dynamic Asset Allocation (DAA) portfolios between an offensive or defensive stance. Based upon years of extensive research we have developed what we refer to as The Macro Risk Indicator (MRI). The MRI is employed in the DAA models to determine whether to emphasize holding defensive assets such as treasury bonds or offensive assets such as equities. The MRI doesn’t forecast the future using obscure economic indicators as the name might suggest, but rather it uses momentum and trend-following to make decisions. Both momentum and trend-following of which have been demonstrated within academia and in practice by some of the world’s top portfolio managers to be the single most robust approach to making systematic decisions in financial markets (To learn more please read our whitepaper on Momentum). We apply the proven concepts of momentum and trend-following on the broad equity market indices such as Vanguard Total Stock Market – VTI or iShares S&P 500 Index – SPY. Why VTI/SPY you may ask? These indices are very good proxies for economic growth expectations that have a measurable and consistent effect on virtually all other assets classes.